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Understanding Lease with an Option to Purchase

Tuesday, June 17, 2008 posted by Tommi Crow

Lease Option Contract

Lease Options, popular in the 70’s and 80’s, are resurfacing  as financing options in the 2008 housing market.    For those unfamiliar with lease options, I will outline what is a lease purchase or lease with the option to purchase?  What are the benefits and drawbacks?  What are the things to watch for? 

NOTE:  Please keep in mind that the information is an overview and is not meant to be construed as legal advise.  Buyers and Sellers should always consult an attorney before signing any legally binding document.

ABC’s of a Lease with an Option to Purchase:

  • The buyer pays the seller an option fee for the right to purchase the property on or before a future date.  The amount of the option fee may be substantial or as low as $1.00.
  • The purchase price can be fixed at the time of contract or set at the fair market value at the time the option is exercised. (Note:  Most buyers will lock in the future price when the option contract is signed.)
  • During the Lease Period, the buyer leases the property from the seller for an agreed upon rental amount.
  • The term of the lease option is negotiable, but the term is usually from 1-3 years.
  • The Option Fee is generally non-refundable.
  • If the buyer does not exercise the option to purchase the property at the end of the lease, the option expires and the seller keeps the option fee.
  • Usually, a portion of the rental amount is applied to the future purchase.  (Example:  If the lease is $1200 per month, the seller will apply a credit of $200 per month toward the future purchase price or down payment.)
  • The buyer can not assign the lease option without seller approval.
  • The Buyer is not obligated to buy the property.

ABC’s of a Lease Purchase: 

  • Includes all the standard terms above with the following exceptions.
  • The option money is non-refundable and does not apply toward the purchase price or down payment.
  • No one else can purchase the property unless the buyer defaults or the option period expires.
  • The buyer is responsible for maintenance, all expenses for upkeep, taxes and insurance.
  • The buyer is obligated to buy the property.
  • The Seller can sue for specific performance in the case of buyer default on a Lease Purchase.

Benefits for Sellers and or Buyers:

  • Lease Purchases or Lease Options are usually offered by distressed homeowners or builders. 
  • The Seller can often get a higher price than they would with a normal sale.
  • The Seller is able to sell the home in a slow market.  Think about it, if the property was easy to sell, the owner would sell it out right for the cash.
  • The Seller benefits from locking in today’s prices and gets relief from paying the monthly mortgage.
  • In theory, the Seller gets a renter that keeps up the property.  Since the renter intends to purchase the property, they should take care of the home, as if it were theirs.
  • The Buyer builds equity through a forced savings plan, as a portion of rent is credited to him, even though the lease payments may exceed market rents. 
  • The Buyer hopes to build equity, if the property appreciates during the option period.
  • Buyers usually make a small down payment, with little to no qualification, which makes lease purchase a good way to ease into home ownership.
  • If the Buyer defaults, the Seller does not refund any portion of the lease payments or the option fee. 

25 YEARS OF REAL LIFE EXPERIENCE:

I have written dozens of Lease Purchase or Lease Option Contracts during the 1980’s real estate crash in Texas.  During that entire period, I never saw one person actually  purchase the property they had an option on. 

The primary reason is often the reason they try to buy with a lease option in the first place…they can’t qualify for a loan.  The second reason for default was that prices continued to fall during the option period and they could buy another home for less money.   The third reason was that the property was in poor condition when they leased it and things became worse with the passing of time. 

If a Seller can not sell, then a lease option or lease purchase may be a sales tool to consider.  They generally generate more monthly cash-flow than renting alone and an option fee is the sellers to keep.  

But note, history proves by a large margin that the tenant will not become the owner, unless their credit situation has improved and the property values increase above the option price.

Bottom Line:  Chances are that 95% of the time, the Seller will get their house back at the end of the option period.